Bond markets in dilemma! Will MPC hike interest rates this week?

Lakshmi Iyer

The outcome of this week's Monetary Policy Committee’s meet is eagerly awaited. Gone are the days when the policy days were deemed ‘non-events’. In fact, given the way bond markets have been oscillating, the curiosity to wait-and-watch to see what unfolds at the upcoming MPC review meet only enhances.

The 10-years G-Sec yield is at 7.85 percent, which when annualised is north of 8 percent. Likewise, one-year treasury bills are trading at 6.80-6.85 percent. High grade corporate bonds have also mimicked G-Sec yields and headed higher.

All this at a time when policy rates haven’t yet been hiked. This elevated curve indicates that rate hikes are already discounted in current yields.

Take the case of Indonesia where we saw two rate hikes in May. The current 10-year G-Sec yield there stands at 7.05 percent or at levels lower than where they were trading prior to the rate hike.

Markets have this uncanny ability to discount events ahead of its happening. That seems to be the case in our bond market too. There is no denying that there is an uptick in economic activity, which is aptly demonstrated by the latest Q4 GDP data.

Additionally, the US has also embarked on a policy rate increase phase, which cannot be ignored.

In 2018 year-to-date, the rupee has been among the worst performers versus the dollar. This has also made foreign portfolio investors a tad worried.

From a year-to-date basis, we have seen net outflows in both fixed income and equity markets with a combined outflow of Rs 30,000 crore.

Also, the banking system seems to be choked with liquidity, another key reason why short term rates have been elevated till now.

How will MPC act in such a scenario? Clearly, the focus seems to be inflation targeting. While headline consumer inflation is well within range (4.58 percent), core Consumer Price Inflation is inching higher (5.92 percent). So, the committee’s view on inflation will be eyed.

There is a high chance that the MPC may want to prepare the market ahead of its departure from its neutral policy stance and gradually pave the way for hiking rates in coming months.

From a market standpoint, the sooner the uncertainty of policy rates abate, the faster we could see stability back in bond markets. Till then, embracing volatility is an art which most bond managers are attempting to master.